The Nobel Committee Honors the Economics of Market Failure

10 Oct by admin

The Nobel Committee Honors the Economics of Market Failure

At first glance, the research of the two scholars who won this year’s Nobel Prize in Economics has little in common. Bill Nordhaus, a longtime professor at Yale, was honored for creating, in the early nineteen-nineties, a mathematical model of how climate change affects the economy. Since Nordhaus developed his model, ones like it have been adopted by many interested parties, including the United Nations Intergovernmental Panel on Climate Change, which has just published a report warning of dire consequences if current trends are allowed to continue. Paul Romer, formerly of Stanford and now at New York University, is a specialist in the forces driving long-term economic growth. The papers that earned him the award, which were published in 1986 and 1990, stressed the importance of knowledge and knowledge generation.

As far as I know, Nordhaus and Romer have never collaborated with each other, and neither of them is associated with any particular school beyond the broad category of neoclassical, mathematically intensive economics. Like most Ivy League economists, they are generally supportive of free-market capitalism. Indeed, they have both written about how the ongoing process of competitive innovation that is intrinsic to modern capitalism generates enormous material benefits, some of which aren’t captured fully in statistics like the gross domestic product.

It is a bit of a paradox, therefore, that what unites Nordhaus and Romer is the work they did studying how market economies sometimes fail to work as advertised. While focussing on separate areas, they both examined the problem of market “externalities,” or “spillovers,” which are a key justification for energy taxes, cap-and-trade schemes, research subsidies, and other types of government intervention. In a background paper, the Nobel Committee noted, “Both Romer and Nordhaus emphasize that the market economy, while a powerful engine of human development, has important imperfections and their contributions have thus offered insights into how government policy could potentially enhance our long-run welfare.”

The term “imperfections” is a bit misleading: the issues here are fundamental. In an idealized competitive market, prices equate the costs of producing goods with the benefits derived by consumers, and this equalizing mechanism insures that markets allocate resources and goods more efficiently than government diktat or other methods. But the markets for fossil fuels (Nordhaus) and goods that embody advances in human knowledge (Romer) don’t work in this way.

When you pay three dollars for a gallon a gas, that price covers the costs that the oil company incurred by extracting oil from the earth, refining it, and transporting it to the gas station, as well as the satisfaction you get from driving your kids to school or going on a road trip. But that price doesn’t account for the costs that future generations will pay when the accumulation of carbon-dioxide emissions in the atmosphere will cause rising temperatures, floods, droughts, the destruction of coral reefs, and so on. This extra cost is a negative externality. One way to deal with it is to impose strict limits on the burning of fossil fuels, such as gasoline and coal. An alternative is to impose a sizable carbon tax, which would reduce their use. But how big should this tax be?

Nordhaus pioneered the development of models that can be used to answer this question. Known as integrated assessment models (I.A.M.s), they incorporate the links from carbon emissions to changes in the atmosphere, and from changes in the atmosphere to changes in global temperature, and from changes in temperature to damaging effects on the global economy. During the early nineteen-nineties, using the first version of his model, Nordhaus calculated that the carbon tax should be set, initially, at about six dollars per ton of carbon emissions. In his most recent work, which takes into account the rapid growth of the world economy over the past quarter century and the concomitant rise in carbon emissions, he has raised his estimate to about thirty dollars.

A positive spillover works in the opposite direction—generating benefits that aren’t fully captured in market transactions. Planting trees is a good example: in addition to providing wood and fruit, trees soak up carbon dioxide from the atmosphere and create oxygen. A less obvious example, which Romer focussed on, is the creation of technical knowledge, which then gets embodied in new commodities.

Take the development of transistors. Scientific researchers at Bell Labs invented them in the late nineteen-forties, and Western Electric started manufacturing them for commercial use in 1951. The customers who purchased the products that incorporated these early transistors, such as hearing aids and radios, presumably got their money’s worth. But that was only the beginning: once the basic knowledge of how to create a transistor existed, other businesses could use it to make different and better products, a process that Romer likened to creating new recipes. “By now, private firms have developed improved recipes that have brought the cost of a transistor down by a factor of 1 million,” he noted in a 1993 essay. “Yet most of the benefits from those discoveries have been reaped not by the innovating firms, but by the users of the transistors. Just a few years ago, I paid a thousand dollars per million transistors for memory in my computer. Now I pay less than a hundred per million, and yet I have done nothing to deserve or help pay for this windfall.”

Romer identified the creation of technical knowledge that spills over into the creation of new products as the key to sustained economic growth. In his 1990 paper, he wrote down a mathematical model of the economy that explicitly included a knowledge sector. He also pointed out that idealized free-market economies, left to their own devices, tend to produce too little new knowledge. In a fully competitive environment, firms will be concerned that other firms will quickly copy any innovations they introduce, so they will be reluctant to make costly investments in research and development.

To deal with this problem, Romer said, it is necessary to introduce policies like subsidies for research and development, scholarships for students of science, and well-designed patents that allow innovative companies to cash in on their inventions. He also argued that there is much policy work left to do, writing, “The country that takes the lead in the twenty-first century will be the one that implements an innovation that supports the production of commercially relevant ideas in the private sector.”

Neither Nordhaus nor Romer is a radical. In the debate about how far to go in tackling climate change, Nordhaus has often been criticized as an incrementalist. In a recent paper, he used his model to calculate that the “optimal” climate-change strategy would involve containing the rise in global temperatures to about 2.5 degrees Celsius by 2100, which would involve setting a carbon tax of about thirty dollars a ton now, rising to about thirty-five dollars in 2020, and to a hundred dollars in 2050. But many climate-change experts, including the I.P.C.C., argue that allowing temperatures to rise by more than two degrees Celsius would be disastrous. At least implicitly, they are advocating much higher carbon taxes than Nordhaus recommends—as much as two hundred dollars a ton in 2020, and then rising rapidly from there.

Romer, who recently did a stint as the chief economist of the World Bank, still favors allowing the market mechanism to guide most of daily life. He is also a big fan of large-scale urbanization, which he believes, among other things, fosters the creation and spread of ideas as long as cities are run properly. Indeed, he is the author of a controversial proposal for impoverished countries to establish “charter cities,” which would be administered by representatives of more advanced countries. No surprise, this proposal led to charges that he was trying to foster neo-colonialism.

In the context of economic theory, however, the key point is that both Nordhaus and Romer long ago recognized the limits of free markets, especially when dealing with long-term challenges such as climate change and encouraging innovation. To many people outside of economics, this may seem like an obvious insight. But it wasn’t obvious to academic economists in the nineteen-eighties, when Nordhaus and Romer began tackling these issues. Back then, as Joshua Gans, an economist at the University of Toronto’s Rotman School of Management, pointed out on Monday, economists were often the ones holding up the adoption of policies designed to abate climate change and foster innovation. Some feared the costs would be too high. Others dismissed industrial policies as counterproductive.

As Gans pointed out, Nordhaus and Romer both created intellectual frameworks that allowed skeptical economists to analyze these two key market failures using tools they recognized as legitimate, and then come down in favor of taking remedial action. Nordhaus and Romer didn’t settle all the policy arguments, not even close. But for what they did do, in a conservative environment, they are deserving of their prize.

Of course, the larger issue today is whether governments can summon the will to introduce the necessary policies, particularly regarding climate change. With a coal-loving climate-change denier in the White House and a Republican-controlled Congress in thrall to energy interests, it seems almost unthinkable that the United States will rise to the challenge. But, at this stage, that is a political problem rather than an economic or scientific one.

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